Chapter 6 Valuation and

Characteristics of Bonds
LEARNNG OBJECTIVES
After reading this chapter you should be able to
1. Distinguish between different kinds of bonds.
2. Explain the more popular features of bonds.
3. Define the term value as used for several different purposes.
4. Describe the basic process for valuing assets.
5. Estimate the value of a bond.
6. Compute a bondholder’s expected rate of return.
7. Explain three important relationships that exist in bond valuation.
OBJECTIVE 1 TYPES OF BONDS
A bond is a type of debt or long-term promissory note, issued
by the borrower, promising to pay its holder a predetermined and fixed
amount of interest per year. However, there are a wide variety of such
creatures. Just to mention a few, we have
· Debentures
· Subordinated debentures
· Mortgage bonds
· Eurobonds
· Zero and very low coupon bonds
· Junk bonds
We will briefly explain each of these types of bonds.
·Debentures
The term debentures applied to any unsecured long-term debt.

·Subordinated debentures
Many firms have more than one issue of debentures outstanding.
In this case a hierarchy may be specified, in which some debentures
are given subordinated standing in case of insolvency.

·Mortgage bonds
A mortgage bond is a bond secured by a lien on real property.

·Eurobonds
Eurobonds are not so much a different type of security as they are
securities, in this case bonds, issued in a country different from the one
in whose currency the bond is denominated.
·Zero and very low coupon bonds
Zero and very low coupon bonds allow the issuing firm to issue
bonds at a substantial discount from their $1,000 face value with a zero
or very low coupon rate.

·Junk bonds
Junk bonds are high-risk debt with ratings of BB or below by
Moody’s and Standard and Poor’s. Junk bonds are also called high-
yield bonds for the high interest rates they pay the investor, typically
having an interesting rate of between 3 and 5 percent more than AAA
grade long-term debt.
BACK TO THE FUNDATIONS
Axiom 1: The Risk-Return Trade-off——We Won’t
Take on Additional Risk Unless We Except to be
Compensated with Additional Return.
OBJECTIVE 2
TERMINOLOGY AND CHARACTERISTICS OF BONDS

Some of the more important terms and characteristics that you might
hear about bonds are as follows:
▪Claims on assets and income
▪Par value
▪Coupon interest rate
▪Maturity
▪Indenture
▪Current yield
▪Bond ratings
Let’s consider each in turn.
·Claims on Assets and Income
In the case of insolvency, claims of debt in general, including
bonds, are honored before those of both common stock and preferred
stock. However, different types of debt may also have a hierarchy
among themselves as to the order of their claim on assets.
Bonds also have a claim on income that comes ahead of common
and preferred stock. In general if interest on bonds is not paid, the bond
trustees can classify the firm as insolvent and force it into bankruptcy.
Thus, the bondholder’s claim on income is more likely to be honored
than that of common and preferred stockholders, whose dividends are
paid at the discretion of the firm’s management.
·Par value
The par value of a bond is its face value that is returned the
bondholder at maturity.

·Coupon Interest Rate

The coupon interest rate on a bond indicates the percentage of
the par value of the bond that will be paid out annually in the form of
interest.

·Maturity
The maturity of a bond indicates the length of time until the bond
issuer returns the par value to the bondholder and terminates or
redeems the bond.

·Indenture
An Indenture is the legal agreement between the firm issuing the
bonds and the bond trustee who represents the bondholders.
·Current yield
The current yield on a bond refers to the ratio of the annual
interest payment to the bond’s current market price.

·Bond Ratings
These ratings involve a judgment about the future risk potential of the
bond.
Bond ratings are favorably affected by
(1) a greater reliance on equity as opposed to debt in financing the firm,
(2) profitable operations,
(3) a low variability in past earnings,
(4) large firm size, and
(5) little use of subordinated debt.
The poorer the bond rating, the higher the rate of return demanded in the
capital markets.
Table 6-1 provides an example and description of these ratings.
 Table 6-1 Standard and Poor’s Corporate Bond Ratings
AAA This is the highest rating assigned by Standard and Poor’s for debt obligation
and indicates an extremely strong capacity to pay principal and interest.
AA Bonds rated AA also qualify as high-quality debt obligations. Their capacity to pay
principal and interest is very strong, and in the majority of instances they differ from AAA
issues only in small degree.
A Bonds rated A have a strong capacity to pay principal and interest, although they
are somewhat susceptible to the adverse effects of changes in circumstances and
economic conditions.
BBB Bonds rated BBB are regarded as having an adequate capacity to pay principal
and interest. Whereas they normally exhibit adequate protection parameters, adverse
economic conditions or changing circumstances are more likely to lead to a weakened
capacity to pay principal and interest for bonds in this category than for bonds n the A
category.
BB Bonds rated BB, B, CCC, and CC are regarded, on balance, as
B predominantly speculative with respect to the issuer’s capacity to pay
CCC interest and repay principal in accordance with the terms of the obligation.
CC BB indicates the lowest degree of speculation and CC the highest. While such
bonds will likely have some quality and protective characteristics, these are outweighed
by large uncertainties or major risk exposures to adverse conditions.
C The rating C is reserved for income bonds on which no interest is being paid
D Bonds rated D are in default, and payment of principal and/or interest is in arrears.
Plus (+) or Minus (-): To provide more detailed indications of credit quality,
the ratings from AA to BB may be modified by the addition of a plus or minus sign to
show relative standing within the major rating categories.
OBJECTIVE 3 DEFINITIONS OF VALUE

· Book value is the value of an asset as shown on a firm’s balance sheet.

· Liquidation value is the dollar sum that could be realized if an asset were
sold individually and not as part of a going concern.

· The intrinsic or economic value of an asset ,also called the fair

value ——is the present value of the asset’s expected future cash
flows. This value is the amount an investor should be willing to pay,
given the amount, timing, and riskiness of future cash flows.
BACK TO THE FUNDATIONS
Axiom 6: Efficient Capital Markets——The Markets Are Quick and
the Prices Are Right. In an efficient market, the price reflects all
available public information about the security, and therefore it is priced
fairly.
VALUATION: AN OVERVIEW
For our purposes, the value of an asset is its intrinsic value or the
present value of its expected future cash flows, where these cash flows
are discounted back to the present using the investor's required rate of
return. This statement is true for valuing all assets and serves as the
basis of almost all that we do in finance. Thus, value is affected by
three elements:
1. The amount and timing of the asset's expected cash flows
2. The riskiness of these cash flows
3. The investor's required rate of return for undertaking the
investment
BACK TO THE FUNDATIONS
Axiom 1: The Risk-Return Trade-off--We Won’t Take on Additional
Risk Unless We Expect to Be Compensated With Additional
Return.
Axiom 2: The Time Value of Money--A Dollar Received Today Is
Worth More Than a Dollar Received in the Future.
Axiom 3: Cash—Not Profits--is King.
The value of an asset involves:
1. Assessing the asset's characteristics, which include the amount
and timing of the expected cash flows and the riskiness of these cash
flows;
2.Determining the investor's required rate of return, which embodies
the investor's attitude about assuming risk and perception of the
riskiness of the asset; and
3. Discounting the expected cash flows back to the present, using
the investor’s required rate of return as the discount rate.
 n
Ct
 (1  k )
t 1
t

OBJECTIVE 4: VALUATION: THE BACIS PROCESS

A basic security valuation model can be defined mathematically as

follows:

V = C1/(1+k)1 + C2/(1+k)2 +… + Cn /(1+k)n （6-2）

where Ct = cash flow to be received at time t

V = the intrinsic value or present value of an asset
producing expected future cash flows, Ct, in years 1 through n
K=the investor’s required rate of return
• Using equation (6-2), there are three basic steps in the
valuation process:
Step l: Estimate the Ct in equation (6-2), which is the amount
and timing of the future cash flows the security is expected to
provide.
Step 2: Determine k, the investor's required rate of return.
Step 3: Calculate the intrinsic value, V, as the present value of
expected future cash flows discounted at the investor's
required rate of return.
OBJECTIVE 5: BOND VALUTION
The valuation process for a bond, as depicted in Figure 6-2, requires
knowledge of three essential elements:
(1)the amount of the cash flows to be received by the investor,
(2)the maturity date of the loan, and
(3)the investor’s required rate of return.
EXAMPLE
Consider a bond issued by American Airlines with a maturity date of
2016 and a stated coupon rate of 9 percent. In 1996, with 20 years left
to maturity, investors owning the bonds were requiring an 8.4 percent
rate of return. We can calculate the value of the bonds to these
investors using the following three-step valuation procedure:

· Step 1: Estimate the amount and timing of the expected future cash flows. Two
type of cash flows are received by the bondholder:
a. Annual interest payments equal to the coupon rate of interest times the face
value of the bond. In this example the bond’s coupon interest rate is 9 percent;
thus the annual interest payment is $90=0.09×$1,000. Assuming that 1996 interest
payments have already been made, these cash flows will be received by the
bondholder in each of the 20 years before the bond matures (1997 through 2016 =
20 years).
Figure 6-2 Data Requirements for Bond Valuation
b. The face value of the bond of $l,000 to be received in 2016. To summarize,
the cash flows received by the bondholder are as follows:

YEARS 1 2 3 4 … 19 20
$90 $90 $90 $90 … $90 $90
+$1,000
$1,090
· Step 2: Determine the investor's required rate of return by evaluating
the riskiness of the bond's future cash flows. An 8.4 percent required rate
of return for the bondholders is given. In Chapter 8, we will learn how this
rate is determined. For now, simply realize that the investor’s required
rate of return is equal to a rate earned on a risk-free security plus a risk
premium for assuming risk.

· Step 3: Calculate the intrinsic value of the bond as the present value
of the expected future interest and principal payments discounted at the
investor's required rate of return.
The present value of American Airlines bonds is found as follows:
bond value = Vb =$ interest in yare 1/(1+required rate of return)1
+$ interest in year 2/(1+required rate of return)2 (6-3a)

+ …+$ interest in year 20/(1+required rate of return)20

+$ par value of bond/(1+required rate of return)20
· Semiannual Interest Payments
In the preceding American Airlines illustration, the interest payments
were assumed to be paid annually. However, companies typically pay
interest to bondholders semi-annually.
First, thinking in terms of periods instead of years, a bond with a life of
n years paying interest semiannually has a life of 2n periods. In other
words, a five-year bond (n=5) that remits its interest on a semiannual
basis actually, makes 10 payments. Yet although the number of periods
has doubled, the dollar amount of interest being sent to the investors
for each period and the bondholders’ required rate of return are half of
the equivalent annual figures. It becomes It /2 and kb is changed to kb /2;
thus, for semiannual compounding, equation (6-3b) becomes
(6-4)
 Alternatively, using the notations introduced in Chapter 5 for
discounting cash flows, the above equation may be restated as follows:
Vb = ($It/2)(PVIFAkb/2,2n) + $M(PVIFkb/2,2n) (6-5)
OBJECTIVE 6
THE BONDHOLDER’S EXPECTED RATE OF RETURN
(YIELD TO MATURITY)
To measure the bondholder’s expected rate of return, kb, we
would find the discount rate that equates the present value of the future
cash flows (interest and maturity value) with the current market price of
the bond. The expected rate of return for a bond is also the rate of
return the investor will earn if the bond is to maturity, or the yield to
maturity. Thus, when referring to bonds, the terms expected rate of
return and yield to maturity are often used interchangeably.
 To illustrate this concept, consider the Brister Corporation’s bonds,
which are selling for $1100. The bonds carry a coupon interest rate of 9
percent and mature in 10 years. (Remember, the coupon rate
determines the interest payment----coupon rate*par value).
In determining the expected rate of return (kb), implicit in the current
market price, we need to find the rate that discounts the anticipated
cash flows back to a present value of $l,1 00, the current market price
(P0) for the bond.
Finding the expected rate of return for a bond using the present
value tables is done by trial and error. We have to keep trying new
rates until we find the discount rate that results in the present value of
the future interest and maturity value of the bond just equaling the
current market value of the bond. If the expected rate is somewhere
between rates in the present value tables, we then must interpolate
between the rates.
OBJECTIVE 7
BOND VALUATION: THERE IMPORTANT
RELATIONSHIPS
We have now learned to find the value of a bond (Vb), given
(1) the mount of interest payment (It),
(2) the maturity value (M),
(3) the length of time to maturity (n years), and
(4) the investor’s required rate of return, kb. .
We also know how to compute the expected rate of return (kb), which
also happens to be the current interest rate on the bond, given
(1) the current market value (P0),
(2) the amount of interest payments (It),
(3) the maturity value (M), and
(4) the length of time to maturity (n years).
We now have the basics. But let’s go further in our understanding of
bond valuation by studying several important relationships.
·First Relationship
The value of a bond is inversely related to changes in the investor’s
present required rate of return (the current interest rate). In other words,
as interest rates increase (decrease), the value of the bond decreases
(increases).

· Second Relationship
The market value of a bond will be less than the par value if the investor's
required rate of return is above the coupon interest rate; but it will be
valued above par value if the investor's required rate of return is below
the coupon interest rate.

· Third Relationship
Long-term bonds have greater interest rate risk than do short-term
bonds.
As already noted, a change in current interest rates (required rate of
return) causes an inverse change in the market value of a bond.
However, the impact on value is greater for long-term bonds than it is
for short-term bonds.
In Figure 6-3 we observed the effect of interest rate changes on a 5-
year bond paying a 12 percent coupon interest rate.
Figure 6-3 Value and Required Rates for a 5-Year Bond at 12 Percent
Coupon Rate\

1,200

$1,117
1,100
Market value

$1,000
1,000

$899
900

800

6 8 10 12 14 16

Required rates of return

 MARKET VALUE FOR A 12% COUPON-RATE
BOND MATURING IN
REOUIRED RATE 5 YEARS 10 YEARS
9% $1,116.80 $1,192.16
12 1,000.00 1,000.00
15 899.24 849.28

Figure 6-4: Market Values of a 5-Year and a 10-Year Bond at Different Required
Rates

1,200

1,100
Market value

1,000

5 -y
ear
900 10 bon
- ye d
ar
bo
nd

800

6 8 10 12 14 16

Required rates of return

THE END